(Recently 12 Senators wrote to CFTC Chairman Gary Gensler urging him to apply higher margins to the energy markets to “restore integrity.” Here is my response:)

Dear Senators:

I applaud your concern about the impact of rising oil prices on American consumers.  No one likes paying more for something than they think it is worth.

Your letter to CFTC Chairman Gensler suggests you have the answer for the higher prices we are currently experiencing.  Your answer seems to be to facilitate less buying by speculators through imposing higher margin requirements for speculative trades.  While that could have the short-term effect you desire (or not), the long term impact would be worse.  Limiting the participation of speculators will make price movements and volatility worse.  Legitimate hedgers seeking to offset their risk will find fewer market participants to take the other side of their trades.  Their cost will be more friction, as there is less grease applied to the markets by the speculators.

More importantly, your solution to high prices is misdirected.  The solution for high prices is not less buying, that is a natural occurring market factor of the price rationing function of markets. The real solution is more selling.

Futures markets are about two key functions; price discovery and risk transfer.  The price discovery process is one where competing buyers and sellers are brought together through a transparent, fair and competitive auction process that involves hedgers and speculators.  Rising prices are an advertisement for more selling.  Rising prices will exhaust their market moving impact as supply is rationed and as people switch to competing products.  But it is more supply and selling that will turn prices back down.

From the price discovery process comes a price signal.  In the commodity markets, that price signal is an important input to producers and consumers.  They use that price information to plan future production or future consumption, depending on their role.  Farmers will use that price to determine which commodity they will plant to bring them the greatest return.  Oil companies use that price signal to help them decide how much to commit to exploration.  Artificially impacting the price signal generated from the price discovery process can have devastating consequences.

Let me draw your attention to the response in Russia to higher wheat prices.  Russia is often a wheat exporter, once the second biggest wheat exporter.  Russia has banned wheat exports in order to limit rising domestic prices.  The result of this government interference (a domestic response to a global market phenomena) has been that Russian wheat plantings are the lowest they have been in 4 years.  Instead of allowing the market price to encourage increased planting, the artificially stunted domestic prices have Russia planting less acres.  Input prices for growing wheat, the diesel fuel for the tractors and fertilizer for the fields, have risen.  That puts even more pressure on production as potential returns are squeezed even more.

Another response to higher prices we are seeing is for politically vulnerable governments to hoard supplies of grain.  This hoarding takes physical supply out of circulation and behaviorally supports the long speculators market-view.

The cause of higher oil prices is not excessive speculation.  But even if it was, we should be focusing ourselves on what are the underlying fundamentals that fomented this excessive speculation?  What is the message from the price signal?  How should we be responding to this price signal?  More selling is the answer.

While we Americans love our SUV’s (I am one of them), there is a bigger issue that is at the heart of the rising commodity prices.  That issue is impact of higher prices for food on those less able to afford it. For many low income people, the choice is not between switching to cheaper food, but being able to pay the higher prices for food at all.  The oil price you addressed in your letter is an important input for food production.  Higher inputs means higher prices are necessary to justify planting.  Higher food prices also mean that fewer economically challenged people will eat, leading to more deaths from malnutrition.  As it is, a child somewhere dies every 6 seconds from a hunger-related disease.  (MEDIA FACT SHEET, United Nations Food and Agriculture Organization).

Should we experience any production disruptions in U.S. corn production this summer, prices could go to unseen levels that would cause a global human tragedy too severe to even think about.

Half steps limiting participation in the price discovery process will not bring any more supply to the market.  It will not generate any new selling by real sellers.  Half steps of limiting position size in U.S. futures markets will do nothing to limit demand for fuel, food, shelter and clothing from fast growing countries like China, Brazil, Russia or India.

Real steps would be finding ways to increase production for commodities and commodity substitutes.  Real steps would be to understand the price discovery process better and to listen to what the price signals are telling us.  Real steps would be to stop looking for scapegoats and instead find solutions.

It is extremely important to get this right.  Millions of lives depend on it. According to FAO report cited above, the renewed economic growth following the financial crisis and the dip in food prices from 2008 highs meant that the number of malnourished people globally fell from 1.023 billion (2009) to 925 million (2010), a difference of -98 million people.

If the speculative response to the market fundamentals has been excessive, perhaps that is an indication that our response to increase supply of these key commodities should be excessive as well.  The markets are demanding a forceful response to the information from the price signal.  We need more supply.  We need more selling.  Let’s find real steps to make that happen.  That would truly bring integrity to the markets.

Respectfully,

John J. Lothian
President & CEO
John J. Lothian & Company, Inc.

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